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Interest rates get interesting again

Tom Stevenson

Tom Stevenson - Fidelity Personal Investing

Interest rates get a lot of attention - even when there’s not much to see. This week, however, the focus looks more than justified. Interest rate policy is interesting again.

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Later today, the Federal Reserve will conclude its two-day meeting and unveil its latest decision. The Bank of England follows suit tomorrow. Neither is expected to announce any change. That sounds dull, but its not because the messaging around the no-change statements could be very different.

Over in Washington, Fed chair Jay Powell is struggling to present a consistent narrative on the outlook for monetary policy. Six months ago, he was on a steady tightening trajectory. Three months later he came over a lot more dovish. Today he faces an apparently strengthening economy but forthright calls from the White House to easy policy even further. What’s going on?

The fact is that the economic messages are mixed in America. On the face of it, first quarter GDP growth of 3.2% looks buoyant. But that number probably overstates the strength of the economy. There was a big contribution from inventory growth and stubbornly weak inflation is telling a different story.

The US economy is a puzzle. On the one hand unemployment at a multi-decade low rate of 3.8% points to a tight labour market and the likelihood of rising wage pressures. But there is no evidence of this to date. If inflation dips a bit further, the Fed may well feel it needs to put in a precautionary rate cut just to keep recession at bay.

No-one is expecting a recession this year, but the bond market has been raising red flags via the so-called yield curve which has a good track record of predicting downturns. The President’s tweets are an indication of how concerned he is about the possibility of a pre-election slump next year. It’s why he is so actively steering the oil price lower too.

So, most Fed watchers expect US interest rates to remain in their 2.25-2.5% range this evening. More interesting is where they go next. The financial futures markets are pointing to the next move being down not up.

On this side of the Atlantic, Governor Mark Carney faces a different dilemma. Over here, Brexit has provided the Bank of England with useful cover to keep interest rates at close to their all-time low. But reduced concerns about a damaging no-deal Brexit and evidence that the UK economy is stronger than feared are putting mounting pressure on the Old Lady to soften her ultra-cautious approach.

Mr Carney has said for many years that interest rates are set to rise slowly. No-one could have predicted just how slowly, though. And as he prepares to move on from the top job early next year, he will want to ensure that he is not remembered as the Governor who let inflation run out of control.

For several months now, wages have been growing faster than prices. The UK central bank is unusual among its peers in presenting forecasts that inflation will run above target for the foreseeable future. The luxury of inaction may not be sustainable for much longer.

Of course, it would be nice for the Bank if it could see how Brexit pans out before coming to a view on inflation and interest rates. But the reality is that inflation could become a problem before there’s any sign of the Brexit knot being untied.

As in the US, we have to be careful with the data. There was a lot of stockpiling by businesses ahead of the expected departure date from the EU in March. That may well have given the economy an artificial boost. And while wage inflation is riding high, there is little sign yet of that feeding through into more general price rises.

So maybe, the Bank can sit on its hands for a bit longer. It is certainly unlikely that it will move this week. More important will be the signals it gives about the future trajectory of rates.

Mr Carney will also be acutely aware that many people are sceptical about the Bank’s credibility. It has promised much in recent years and stepped back from action at the last minute. In the dying months of the Governor’s tenure he may well try and provide a bit more clarity.

So, what do the potentially different flight paths of interest rates on either side of the pond imply for investors?

If rates do start, even slowly, to converge then the pound may well surprise on the upside. The prospect of a softer Brexit, or no Brexit at all, might underpin that re-alignment of currencies.

A stronger pound would, of course, not be good for Britain’s export and overseas-earnings focused FTSE 100. We should sometimes be careful what we wish for.

We need to put this in perspective, however. By historic standards, interest rates are likely to remain lower than the historic norm on both sides of the Atlantic. That means the returns from cash and bonds will also remain disappointing.

Just this morning, Sainsbury’s announced an 8% rise in its annual dividend. At the current share price, the supermarket yields 5%. It is far from alone among Britain’s biggest companies. The income offered by British shares is attractive compared with both their own history and other asset classes too.

The Select 50 has a range of income-focused funds, investing in the UK, Europe, the US and globally.

A highlight of this last group is the Fidelity Global Dividend Fund, one of four Tom’s Picks recommendations this year.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.